Author’s Note: This post is taking an economic and investor approach to The Securities Act of 1933. This is not to ignore the time and monetary cost of information. It is merely a critique of one portion of a larger regulatory scheme and its effects.
The purpose of the 1933 Securities Act was to protect investors by providing them with information in order to make a sound investment decision. Albeit not articulated at the time of The Securities Act’s inception, the modern application of the Securities Act reflects the Capital Asset Pricing Model and the Efficient Capital Market Hypothesis. Roughly, the efficient capital market hypothesis assumes that the market and the stock prices are a reflection of information available about that security.(1) As the original standards for reporting requirements and disclosure requirements of the Securities Act have loosened in recent years, have we cheated investors? Are investors not being fairly compensated or informed for the risks they have assumed?
When a security becomes available to the public for the first time, the SEC requires certain disclosures through its registration statement. The registration statement provides basic information about the company and basic financial information. During this process, there are underwriters who analyze and then provide the first price for the security. They will consider the projections of the company, the segment in which it operates, as well as general global and national market conditions. Their ultimate goal, however, is to sell the securities. The underwriters receive a percentage of the final sales price, which incentivizes them to have a higher price than potential fair market value. The SEC helps to regulate this process and civil liabilities and administrative action can provide a disincentive to be overly optimistic about the security’s prospects.
Since 2005, there has been a movement towards reducing the information required from issuers prior to offering securities to the public. One category of companies, Well Known Seasoned Issuers (WKSI), are completely exempt from having to file a registration statement with the SEC prior to offering securities. There is no additional information required about the security. While WKSI’s are reporting companies and they have to provide statements to the SEC, there is not nearly the amount of scrutiny placed on their statements as there are for non-reporting companies who are initiating a public offering. Moreover, Regulation D allows for an even larger information gap. Certain provisions under Regulation D permit offerings of an unlimited dollar amount, so long as the offering is only available to accredited investors. “Accredited investors” is a defined term, although it can apply to a wide range of people and businesses, and it does not consider the sophistication of those individuals. For example, an individual with a net worth of at least $1 million, less the value of his or her primary residence, is an accredited investor. This could include people who are wealthy, but are financially unsophisticated such as medical doctors, lottery winners, individuals with large inheritances, etc. Under the current law, when the offering is limited to accredited investors, the companies offering the securities do not need to provide any information or disclosure to the investors.
The move toward lesser disclosure standards has costs. A rational investor would use the information from the disclosures to assess the risk of their investment and determine what return they would want on their investment as compensation for taking this risk. This is the risk premium. The risk premium is any additional return above the risk-free rate of return (e.g. the return on US treasury bonds). The higher the risk the investor bears, the higher return expected.
If there is no information disclosure required and the company did not violate some other law, such as fraud, misrepresentation, and so forth, the investors do not have the ability to rescind their investment. Imagine the situation where the investors, having had full disclosure, would have assessed a risk premium of 15%. However, the investors only received a 10% return. While returns are not guaranteed, the investors would have discounted their investment further because they were not able to fully assess their risk or may not have been willing to bear the risk for only a 10% return. The offeror essentially deprived investors of an additional 5% return. Furthermore, even if the company had violated a securities law, the remedies available do not account for this type of situation. The best that investors could do is rescind, less the money gained on the security.(2) If suing for the extra 5% were a valid remedy, it would be difficult to prove that there was some sort of financial loss, or that a higher return would have been more appropriate under the same market conditions.
I do not think that a lawsuit to recover the risk premium should be a valid remedy, because then the government would be required to play the “what if” game. To avoid this dilemma, I think it is necessary to require companies to provide investors with the relevant financial information necessary to make a fair assessment of risk, and allow the investors to determine the level of return they would see fit as a risk premium. The underwriters are in the game of selling. There are high pressure tactics and one sided information. If the SEC continues to head down the path of non-disclosure, we lose the protections for investors to make smart decisions about where to place their money and where they can receive the best return. As a friend of mine says, compensating investors for a risk premium is the difference between gambling at the casino and gambling on the stock market. If we are not giving investors sufficient information to have a fair assessment of risk premium, they might as well be playing poker because the odds are in favor of the house.
(2)15 U.S.C. §77k, §77l, §77p; Wis. Stat. §551.509